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Understanding FICO Credit Scores

For the first twenty years of your life, the most important measure of your future were your grades in school. Scored well, you got into better schools and tougher classes. Scored poorly and you didn’t. Just about the time I thought grades stopped mattering, I learned about my FICO credit score.

This little three digit number has caused so much consternation in its lifetime you’d think it was invented hundreds of years ago. Would it to surprise you to learn that the FICO score, for all its flaws, is actually an improvement on its predecessor? Before the Fair Credit Reporting Act in 1971 (full text of the FCRA [3]), credit reporting agencies did whatever they wanted.

They collected whatever information they could find and sold it to whomever was willing to pay. The idea of a “credit score” didn’t emerge until the 1980s when Fair Isaac Corporation (FICO) put the data through a magical black box equation and spit out a three digit FICO score.

Pique your interest? Enough of the history lesson, let’s learn about FICO scores, how they are calculated (as best we know), and get on with this Foundation Series [4] post!

One FICO Credit Score

Fair Isaac Corporation (hence the acronym FICO) created the FICO credit score. The three digit number ranges from 300 to 850, with a higher score being better. The score is used, with other factors, for two decisions:

  1. Whether or not to extend you credit,
  2. The interest rate to charge you for that credit.

The idea behind the credit score is that it gives an indication of your creditworthiness. A person with a higher credit score is more likely to repay their debt than a person with a lower credit score. Lenders use this information in lending decisions because they want to know about a borrower before they lend them money! Lenders also accept that a certain percentage of their loans will default but they use credit scores to ensure that they still run a profitable operation.

Other credit scores: There are a few other credit scores out there but none have the popularity and history of the FICO score. The three major credit bureaus tried to band together to create VantageScore, a FICO score competitor, but each continues to offer a FICO score because of its popularity. Since many lenders and creditors use FICO scores, so should you.

Three Major Bureaus

There are three credit reporting agencies: Equifax, TransUnion, Experian. Equifax is the oldest of the three, having been founded in 1899, and is based out of Atlanta, GA. Experian is an international company with corporate HQ in Ireland and an operational HQ in Costa Mesa, CA. TransUnion is the third largest and began as a subsidiary of Union Tank Car Company in 1968, but is now an independent company located in Pennsylvania.

Wonder why your scores differ across the three? Slightly different formulas but mostly because of inaccurate information. Unfortunately the credit reporting system in the United States is voluntary. Companies are not required by law to report your credit activity and so the reporting can be uneven. For example, most credit card companies won’t report late payment unless it’s over 30 days or 60 days late. They don’t report it because they don’t want the added expense of reporting it, especially if they can avoid it and build up goodwill with the customer.

What It Considers

There are five major categories included in your FICO score:

  1. 35% — punctuality of payment in the past (only includes payments later than 30 days past due)
  2. 30% — the amount of debt, expressed as the ratio of current revolving debt (credit card balances, etc.) to total available revolving credit (credit limits)
  3. 15% — length of credit history
  4. 10% — types of credit used (installment, revolving, consumer finance)
  5. 10% — recent search for credit and/or amount of credit obtained recently

As you can see, the categories are broad and the percentages are merely guidelines. This is done by design because Fair Isaac doesn’t want you to know the equation because you’ll try to game it. Fair enough! Fortunately, it does include enough information to give you an idea of what you’ll need to do if you want to improve your credit score.

What It Ignores

Everything else. It doesn’t take into account you (so no race, religion, age, gender, and marital status as required by the Federal Reserve Board’s Regulation B), your jobs (salary, title, employer, employment history), current rates (what you’re paying on a mortgage or car note or student loans), and extracurricular credit activities (such as credit counseling, because it’s not reported).

Five Facts to Know

  1. Every year, you are entitled to a copy of your credit report through the government’s AnnualCreditReport.com [5] website. You will want to pull this once a year to check for inaccuracies or errors. Do not go anywhere else to get your free report. You will not get your credit score.
  2. If you spot an error, dispute it as soon as possible. The dispute resolution process can take a long time, with a lot of information verification, so you’ll want to start it early, even if you don’t think it’ll matter.
  3. There are no quick ways to increase your credit score. Credit score repair companies will promise you anything, but there’s not much you can do in the short term to increase your score. Those companies usually try to either trick the bureaus into removing negative items or trick you into paying them for nothing.
  4. Credit scores can sometimes be used in untraditional ways. Some employers are using credit scores to make hiring decisions!
  5. If you want your score, you have two options. The first is to use a credit score estimator [6], which seem to be reasonably accurate [7]. The second option is to sign up for the myFICO ScoreWatch 30-day trial [8], getting your score, and then canceling the subscription.

This is by no means an exhaustive look at credit scores but hopefully I’ve armed you with a good enough understanding and a large enough vocabulary that you can do more research. If there’s something I missed that you think I should include, please let me know!

(Photo: Andres Rueda [9])